Falling Home Prices Mean Canadians Will Feel Poorer. That Could Be Bad For The Economy

Never underestimate the importance of psychology to the markets.

As Canadians' home values grew and grew in recent years, many people became intoxicated with the idea that they were now paper millionaires.

Even as their children complained they would never be able to buy a house, many older Canadians with comfy suburban homes cheered on the housing boom — and went shopping.

Watch: This is Canada's most expensive condo (story continues below)

Economists have a term for this behaviour: it's called the "wealth effect," and it means that when people feel richer, they spend more — even if they don't necessarily have a cent more to spend than they did before.

"If your house is suddenly worth 20 per cent more, even if you don't have more money, you feel richer," said Jocelyn Paquet, an economist at National Bank Financial (NBF).

You're being irrational

In many cases, the wealth effect is not rational. An increase in your equity doesn't actually make you "richer" on a day-to-day basis. Your stock portfolio may have soared, but it's all stuck in a retirement plan until you turn 65. The value of your house has doubled, but so has the value of everyone else's house, so you're no better off if you sell your home and need to buy a new one.

But what really does change is the debt people carry. It's no coincidence that, as house prices rose faster than incomes over the past 15 years, the amount of household debt in Canada soared to nearly $1.70 per dollar of disposable income, from around $1.10 in the early 2000s.

And here's the thing: Those equity gains can disappear when a housing (or stock) market cools ... but the debt remains. Being saddled with a whole bunch of debt and not much wealth makes people feel, well, not very rich.

Earlier on HuffPost Canada:

And now, with Canada's housing market moving into cooling mode, this debt-fuelled "wealth effect" could quickly come to an end, economists at NBF said in a client note this week.

"We're not there yet, but the present trend has caught our attention," Paquet and fellow economist Stefane Marion wrote. "If things don't stabilize soon, an eroding wealth effect for consumers will become a headwind to growth in 2019."

The National Bank's index of house prices, released Thursday, showed that of 26 Canadian metro areas covered, 40 per cent have seen falling house prices in the past six months. And all but five of them —Montreal and the Ontario cities of Kingston, Kitchener, St. Catharines and Windsor — have seen prices fall from their peak.

National Bank FinancialHome prices are past their peak in 21 of 26 Canadian cities.

What happens when the wealth effect reverses?

The wealth effect has arguably played a role in Canada's strong economic performance in recent years. Paquet noted that since around 2007, Canada has seen the fastest economic growth among G7 countries, a growth that was driven by consumption, which rose along with house prices.

When homeowners start feeling poorer, they will adjust their spending downwards. That will slow the retail sector, putting pressure on many businesses and slowing employment growth. That decline in employment will make it harder for some to pay their mortgages, putting further downward pressure on real estate.

Lending will decline. Fewer people will be taking out HELOCs on their homes, and the loans they can qualify for will be smaller. That will slow down the financial sector.

4.5 cents on the dollar

In all, there will be downward pressure on the economy. But how bad it will be is anyone's guess. In a recent study, Moody's Analytics tried to put a number to the wealth effect. They came up with 4.5 cents: For every dollar you gain in perceived wealth, you spend an extra 4.5 cents.

And vice versa, if you're getting poorer.

So let's say the average house price in Greater Toronto drops by $50,000 (leaving it at a still hefty $730,000 for all housing types). If Moody's is right, the typical Toronto homeowner will reduce their spending by about $2,250 a year. Multiply that by the hundreds of thousands of homeowner households in the region, and that amounts to a serious economic headwind.

To be sure, the great consumer collapse isn't happening yet — though recent data does suggest retail spending in Canada is losing steam. Paquet noted that consumption has slowed down from an annual pace of growth of 3.5 per cent in 2017, to 2.2 per cent this year and 2.1 per cent next year, according to NBF's projections.

Still some reason for optimism

But Paquet sees something positive on the horizon: booming foreign trade numbers. NBF forecasts the rate of trade growth will hit 4.6 per cent in 2019, up from 1.1 per cent in 2017. So trade and business investment might just save Canada's economy from a consumer-led slump.

"We can say for sure that the peak is behind us in terms of consumption in this cycle," he told HuffPost Canada by phone.